1. Introduction
The worldwide stock of foreign sourced capital is approximately 6 trillion, and with annual flows of FDI in excess of 650 billion, it is not surprising that an extensive
literature has emerged to explain how MNEs internationalise and manage their operations, and how their activities impinge upon host countries. It is widely
acknowledged that MNEs can generate employment and exports, and research is ongoing into the nature and extent of secondary spillover effects on indigenous firms.
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Governments throughout the world compete vigorously to attract MNEs, and international business scholars continue to debate the net benefits of this for the host
countries see Haaland and Wooton 1999, Head, Ries and Swenson 2000 and Agmon 2003.
In this paper, we focus on a hitherto neglected effect of FDI on host countries. Using an amended version of portfolio theory that has been widely applied in the
regional science literature, we show how foreign MNEs can reshape the industrial structure of small and medium sized countries. Governments of such countries can
attract foreign MNEs that operate in dynamic growth sectors in order to create a more completely diversified industrial structure that will generate faster growth. As
Chandra 2003 demonstrates, however, faster growth is generally accompanied by greater volatility and risk. Business analysts and commentators have also expressed
concern that attracting foreign MNEs can be risky if the sectors in which they operate are more volatile than the host country. The essential insight of portfolio theory,
however, is that an appropriate mix of foreign MNEs can help the host country achieve a more complete diversification of its industrial structure, and to grow faster
without a commensurate rise in volatility. This occurs to the extent that the foreign MNEs operate in sectors that covary imperfectly with other sectors in the host
country. Our findings are of interest to policymakers in designing and implementing their FDI strategies, and to MNEs in negotiating with potential host governments.
We focus on Ireland as a case study. This country is of interest to international business scholars for two main reasons. First, Ireland has achieved international
recognition for its success in attracting FDI. Through its network of overseas offices, the country’s Industrial Development Agency IDA Ireland markets Ireland as an
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attractive location for high-technology MNEs by emphasising the competitiveness and stability of the economy, the skills base of its highly educated workforce, the
favourable tax regime, and the available financial incentives. Over 1,050 foreign MNEs have located in Ireland. Many of these 507 are from the United States, with
148 being from Germany, 129 from Britain, 216 from the rest of Europe including France 42, the Netherlands 34, Switzerland 26 and Sweden 21, 55 from the
Far East including 33 from Japan, and the remaining 39 from the rest of the world.
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They are involved in a wide range of activities in sectors as diverse as e-business, engineering, financial and international services, information communication
technologies, medical technologies and pharmaceuticals. Their presence has contributed significantly to transforming a largely agricultural developing country into
the knowledge-based ‘Celtic tiger’ that grew at rates in excess of 10 percent during the late 1990s, and which continues to prosper in the first decade of the 2000s by
exporting almost 100 percent of its GDP.
The second reason why Ireland is of interest is that size matters in international business. Lacking a substantial consumer base, small countries cannot take advantage
of economies of scale and scope unless they make a strong commitment to export. Of the 227 countries in the world in 2004, less than a quarter 50 have populations
greater than 20 millions, and 30 countries have between 10 and 20 million people. A further 50 countries have between 3 and 10 millions, and the remaining 97 43
percent have populations of less than 3 millions. With just under 4 millions, Ireland has close to the world’s median population of 4.5 millions, and it occupies the lower
end of the 3 to 10 million group which includes Austria, Bulgaria, Denmark, Finland, Israel, New Zealand, Norway, Paraguay, Sweden and Uruguay. Many of these
countries have emulated Ireland’s successful FDI policies, and they in turn have been studied by international business scholars seeking to understand the causes and effects
of FDI. The effects of FDI on industrial structure depend on a country’s size, and our paper has most relevance for the world’s many small and medium-sized countries.
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We examine 25 years of Irish manufacturing employment data for indigenous firms and foreign MNEs at various levels of aggregation from 1974 to 1999. In 1974-
75, indigenous firms accounted for two-thirds of all manufacturing jobs in Ireland, and foreign MNEs accounted for the rest. By 1998-99, MNEs accounted for almost
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half of all manufacturing jobs. We ask two main questions. First, how have foreign MNEs altered the mean-variance characteristics of Ireland’s manufacturing sector?
More specifically, has the growth in the share of foreign MNEs relative to indigenous firms led to higher rates of overall growth at the expense of greater volatility and risk?
Second , if the answer to the first question is yes, has the faster growth been achieved
at a cost in terms of volatility that compares favourably with the risk that would be borne on a mean-variance efficient frontier? We find that attracting foreign MNEs in
fast-growing, high-technology sectors has indeed generated faster growth with greater volatility. This increase, however, has been mean-variance efficient. By this we
mean that while the high-technology sectors in which foreign MNEs dominate are more volatile than the indigenous sectors which largely comprise low-technology
industries such as food, beverages, textiles and clothing, the greater rates of growth amongst the foreign MNEs have more than compensated for the additional risk.
Because their growth rates are imperfectly correlated with the indigenous firms, Ireland’s foreign MNEs have created a better diversified manufacturing sector that
grows faster with a less than commensurate rise in volatility and risk.
Our paper is structured as follows. In the next section, we present our data and review the main developments that have occurred during 25 years of manufacturing in
Ireland. Using Herfindahl indexes, we show that diversification has improved over time. We also present estimates of Sharpe’s 1970 single index model for each
sector. This demonstrates the extent to which the foreign MNEs have grown faster on average, and are more volatile than the indigenous firms. In section 3, we first present
an aggregative portfolio analysis using 2 sectors; indigenous firms and foreign MNEs. This simple framework illustrates the extent to which the expanding share of foreign
MNEs has led to a better diversified manufacturing sector that can grow faster without a commensurate rise in volatility. We then consider a 10-sector model in which we
divide the firms into low-technology and high-technology sectors. We get virtually the same results as the more aggregative 2-sector model. This is not surprising,
because IDA Ireland has sought to attract high-technology foreign MNEs. We finally consider a more disaggregated 20 sector model with 10 indigenous sectors and 10
foreign MNE sectors. As a robustness check, we impose constraints on the extent to which the sectors can evolve over time, and we derive a correspondingly constrained
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efficient frontier. We derive virtually identical results in each specification. Our final section summarises our arguments and draws together our main conclusions.
2. Ireland’s Manufacturing Sector
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